Dividend investing for outsized returns

Looking at whether a share price rises or falls during stock market trading is only half the picture. How much the company pays in dividends can be equally as important.

Anyone who has had the good fortune to have had a large amount of money to invest over recent years will know what a challenge it is to find a decent, steady return on their money.

Investing in stocks that pay attractive dividends, or equity income investing as it is known, can be a good way to generate relatively solid, attractive levels of income over time.

Higher levels of income

While investing in stocks is far from being without risk, the average dividend yield on a FSTE 100 company is 3.86%, seemingly far more attractive than the interest rate offered by a high street bank account.

Some companies tend to pay much more in dividends than others, so if you target the higher dividend paying stocks it should be possible to generate even higher levels of income.

For instance, FTSE 100 oil majors BP and Shell currently have dividend yields of over 6%.

Reinvesting dividends

Reinvesting the dividends you receive from your equity portfolio can lead to much higher returns over time than you would get from just the capital appreciation of the underlying shares alone.

That is, if you use the dividends you receive to buy more shares in high-yielding stocks that continue to rise in price over time.

Neil Woodford is one of the most celebrated fund managers of all time and a pioneer of equity income investing. When he was at investment firm Invesco Perpetual, £1,000 invested in his equity income fund would have grown to £23,000 over a period of 25 years.

As a general rule of thumb, the more frequently you receive and reinvest your dividends, the higher your long-term returns are likely to be.

Those of us who are looking for periodic income from our investments may prefer to sacrifice this potential longer-term gain to instead receive the dividend payments in cash as they arise.

Distributing the profits

So, what are dividends anyway? An important thing to remember about dividends is that they are normally expected to be paid out of a firm´s profits.

Dividends are, therefore, by their very nature far from guaranteed, and can fluctuate from year to year.

Being paid directly out of a firm´s profits, dividends are a means of distributing earnings generated by the business to shareholders.

Dividend yield

A typical dividend-paying FTSE 100 firm will make two dividend payments during a financial year. Added together these two payments form the annual dividend paid by the firm, which is then used to calculate the firm´s dividend yield.

The dividend yield on a given stock is simply the annual dividends received by shareholders, divided by the company´s market capitalisation on the stock market.

It tells us the percentage yield over a year that we will receive on the shares if we buy into the shares at that point in time, and providing the company chooses to maintain its current dividend policy.

However, even if the dividend payments themselves stay the same, the dividend yield on a stock will fluctuate as the share prices moves in the market.

For this reason, a big share price fall can boost a stock´s dividend yield.

Ex-dividend

Companies tend to disclose the amounts they will pay to shareholders for the year when they publish their financial results.

By visiting the investor section of a company´s website, you should be able to find the firm´s financial calendar with the actual dates on which it plans to make dividend payments.

On the calendar, you should see a “record date”, which is the date you must be on the company´s record as a shareholder in order to receive the dividend payment.

When the shares are said to trade “ex-dividend”, it´s too late for someone to purchase the shares in the market and be eligible to receive the dividend. Put another way, once ex-dividend, the dividend payment belongs to the seller of the shares rather than the buyer.

Once a stock has been declared as ex-dividend, the shares will normally drop in value by the amount of the dividend. Therefore, prior to the ex-dividend date, the value of the dividend tends to be factored into the share price.

Prior to the ex-dividend date, the value of any dividend is captured in the share price.

Consistent

In practice, the big FTSE 100 companies tend to keep their dividend policies relatively consistent over time. Investors don´t like negative surprises, so companies are reluctant to cut their dividend.

This also means that the big blue chips tend to think very carefully before they announce an increase in their dividend. To maintain credibility with institutional investors, they need to ensure that they can afford to at least maintain the dividend over the long-term.

The impact of all this tends to be that those companies with the more consistent revenues and earnings are the ones that will pay the highest dividends.

Defensive companies such as banks, insurers, utilities and tobacco firms have historically generated steady profits that have allowed them to maintain good dividends over time.

Henderson study

The phenomenon was highlighted by a recent study from fund manager Henderson Global Investors. It found that the same ten UK stocks were held within 70% of UK equity income funds, vehicles which target investing client money in the UK stocks perceived as offering good dividends.

The stocks were:

• AstraZeneca
• Aviva
• BP
• British American Tobacco
• GlaxoSmithKline
• HSBC
• Imperial Brands
• Legal & General
• Royal Dutch Shell
• Vodafone

While most of these names trade within the defensive sectors, two of the companies on the list are big pharmaceuticals players; GlaxoSmithKline and AstraZeneca, which currently have dividend yields of 5.4% and 4% respectively.

With the share prices of oil companies having come under pressure over recent years, Royal Dutch Shell and BP stand out with especially high dividend yields, at 6.3% and 6.2% respectively.

Royal Dutch Shell currently has a dividend yield of 6.3%.

Typical fund

At present, a typical UK income fund will have a dividend yield of around 4%. In investment management industry terms, such funds can also be concentrated as they struggle to find enough higher dividend paying stocks to incorporate.

Long-term performance from such funds though has generally been good. For example, as at 31 August 2017, the Schroder Income Fund had risen 108% versus 79% for the FTSE 100 index benchmark over ten years.

As at the end of August, the Schroder fund had just 37 holdings and offered a dividend yield of 3.9%.

Caveats

Investing in companies that pay good dividends over time can reap strong rewards, especially if the dividends received are reinvested in an equity income portfolio to compound returns over the long term.

At the same time, firms that pay decent dividends should normally be financially healthy, with consistent revenues and earnings.

However, there are some caveats; there have been instances where certain firms are so averse to cutting their dividends that they have actually resorted to using borrowed funds in order to maintain the payments.

In such cases, the companies fear a negative reaction from their institutional shareholders, but likely expect their earnings to rebound so they will be able to continue their dividend policy in the longer term.

Missed opportunities?

Another issue is that focusing too narrowly on dividends could mean we are passing up some big long-term opportunities on stocks that have stronger growth prospects.

Such firms may choose to retain more of their profits so they can reinvest in their business with a view to generating even greater earnings in the future.

In practice, many companies allocate capital from their earnings to both reinvest in the business and make dividend payouts to shareholders.

Long-term challenges?

Investors could also ask themselves whether certain firms are making higher dividend payments because they are unable to identify good growth prospects themselves in which to reinvest the funds.

Out of some of the main sectors that pay higher dividends, tobacco and oil are facing long-term challenges to their businesses; tighter regulation by governments is leading to lower cigarette sales while the outlook for oil is being hampered by the growth in green technologies, such as electric cars.

When a firm has a much higher dividend yield than average, it could be a sign that the share price has actually fallen substantially. If a slowdown in earnings is the underlying issue for the share price fall, it may not be too long before the company cuts its dividend payments.

Equity income investing has brought some excellent returns over the years, but as with all equity investing it requires a high level of research to get it right. But doing so really could pay dividends.